Sunday, January 22, 2017

Is This Market Headed Higher or Lower?

If you check out the recent market review from Jeff Miller, you'll notice something interesting:  U.S. economic data are quite strong.  The Philly Fed index of business conditions, for example, has been rising strongly, exceeding expectations.  Jobless claims are at unusually low levels, the opposite of what we'd expect if we were on the verge of recession.  

Interestingly, my model of stock market sentiment has been on the bearish side over the past week.  That model looks at the ratio of put option activity to call option activity for all listed stocks (not indexes) and exchanges.  The regression model takes out the overall impact of implied volatility for the market overall and recent price change, so that we can see--for a given level of $VIX and recent price change--whether market participants lean bullishly or bearishly.  When they are relatively bullish (model below zero), the next ten days in SPY, going back to 2014, have averaged a loss of -.15%.  When traders are relatively bearish (model above zero), the next ten days in SPY have averaged a gain of +.69%.

The stock market has been correcting in recent weeks, which can be seen in the above graphic that tracks intermediate-term market strength.  This measure is derived from the number of SPX 500 shares that make fresh 5, 20, and 100-day new highs versus lows.  (Raw data from Index Indicators).  What we've been seeing is a diminishing number of shares making new highs.  On an intermediate-term basis, we've also seen some expansion in the number of stocks making new lows.  For example, across all exchanges, fresh one-month new lows have outnumbered new highs for the past four trading sessions.  

With respect to the major averages, it's been a relatively flat correction to this point, with more sector rotation than outright weakness.  We're trading at about the same level in SPY as we were in mid December.  My ensemble model, which combines individual models related to such factors as buying/selling pressure; volatility; sentiment; and breadth, has been leaning bearish for the past week.  That leaves me open to the possibility of further correction, as the model anticipates price change two weeks forward.  The rotational nature of this correction, the strength in economic data, and the strength of the post-election rise (which saw a meaningful expansion in the number of stocks participating on the upside) all lead me to believe that any such weakness will indeed be part of a correction and not an outright bear market.

Should rates continue to rise as part of a gradual normalization of Fed policy in response to a firmer economy and rising inflation, we could see a movement out of fixed income and into the stock market.  That would especially be the case if the tailwinds of coming economic stimulus look to outweigh headwinds that could come from restrictive trade policies.  If we, indeed, were to get further correction in stocks and even more bearishness from sentiment data (as anticipated by the trading model), the investor in me would be looking to scoop up some values.

Further Reading:  The Trading Model